Wednesday, August 11, 2010

I left the following comment at this post on Falkenblog, which was itself in response to this post by Paul Krugman:

Krugman contemptuously ridicules Paul Ryan's proposed budget because it freezes discretionary spending in the future, as if this modest fiscal restraint is insane. How is this sustainable?

Government can choose one of two options:

1) The government can reduce spending at the same time as households and businesses (which is what Ryan's plan amounts to), resulting in a fall in aggregate demand and concomitant rise in spending due to increased welfare provision and falls in tax revenue due to falls in GDP.

or

2) The government can borrow to increase spending, thus stimulating demand and increasing GDP, thus increasing tax revenues, allowing the government to service the debt it has incurred.

"In a private company, if you are losing money you cut until revenues meet expenses"

Clearly you have never worked in a high-tech startup.

Many businesses "lose" money for years before they start making profits. They borrow money to invest in future growth, much as the US government can borrow to invest in future growth.

2 comments:

Anonymous
said...

You fail to appreciate the nature of economic growth.

It is doing more and more with existing finite resources. Unless you're discovering new resources, then economic growth has to be about figuring out new ways of squeezing more out of those resources. i.e. through division of labour, innovation, technological development, etc.

For economic growth to occur, you essentially need change. Now if you're just out of an economic crisis, then you need capital to be reallocated to new areas, and new entrepreneurs, and possibly even some existing businesses depending on success. It's up to the market to decide what's best - after all, the market is one giant experimentation process. That's why it seems so harsh sometimes, when you end up on the wrong side of the experiment and need to adjust.

This means you can't just keep spending more. The nature of government spending is that someone has to be receiving it, so you're essentially perpetuating the old system that's just failed. You see, by labelling it aggregate demand, you've failed to appreciate everything that occurs under that label. Capital now needs to be reallocated, and continuing spending on the misallocated capital will actually prevent it being reallocated. If anything, by continuing spending, you're holding back growth.

Now, you could argue that spending therefore should be concentrated on non-economic areas, like public services. But then how will spending more on these in any way benefit aggregate demand? After all, this would just mean churning money that's already been taken from the economy through taxation and future taxation (debt).

You could argue that decreasing taxation may be a good way to deficit spend, but then you still need to cover your high spending and debt repayments.

The only alternative then is to cut back on both spending and taxation, whilst reducing the deficit. It would mean high short-term falls in economic growth, but then be followed by high and sustainable growth. By continuing either deficit spending or high levels of spending, you end up with long recessions followed by pitifully small and weak recoveries, which are unsustainable.

1) Markets as "experimentation processes." My point has nothing to do with the merits or otherwise of using markets to allocate R&D spending.

The problem is a fall in aggregate demand caused by firms choosing to hold cash, rather than invest in innovation. So if private businesses won't, why not have the state do it?

2) Government spending as "propping up a failed model."

I'm not advocating that governments bail out failed companies, just that they employ otherwise unemployed people to do useful work.

Examples could include (here in the UK) laying down fast broadband to rural areas. This would provide a lot of employment, and hence stimulate the economy and reduce unemployment.

3) Public services as "non economic areas."

Um. What?

Public services are economic activities, are they not? Nurses and fire fighters and teachers provide necessary and important services that are paid for through the tax system, because provision through markets of these particular services is problematic.

And as for this:

"By continuing either deficit spending or high levels of spending, you end up with long recessions followed by pitifully small and weak recoveries, which are unsustainable."

It's the other way round (as suggested by the recent reversal in UK growth since the coalition government started cutting gov spending in order to "reduce the deficit"). By *not* deficit spending you endanger short run and medium term growth.